BA606 FINANCIAL ACCOUNTING

1. BA606 FINANCIAL ACCOUNTING Professor Garry Carnegie Lectures 11 & 12

2. Lecture 11: Cash flow statement Introduction Funds statement Definition of funds Reporting cash flow information Accounting standards

3. Introduction The cash flow statement is one of four financial statements resulting from the financial reporting process The cash flow statement provides information about an entity’s operating, investing and financing activities Prior to the requirement to prepare cash flow statements in Australia, it was necessary to prepare funds statements

4. Funds statement The funds statement was also known as a “statement of funds flow” or a “statement of sources and applications of funds” This statement was deemed to be necessary as the balance sheet and income statement did not present a complete picture of an entity’s economic activities The statement was seen as necessary to summarise investing and financing activities

5. Funds statement The first Australian accounting standard on this topic was issued in 1983 This standard adopted the “total resources” concept of funds The standard did not require the disclosure of cash flow information AASB 1026 “Cash Flow Statements” was issued in December 1991 Now, AASB 107 (of the same title) applies

6. Definition of funds An increase in funds is a “source” of funds A decrease in funds is a “use” of funds The use of funds is also known as the “application” of funds There are three conceptions of funds: - Cash - Working capital - Total resources

7. Definition of funds Cash Where funds are interpreted as cash, any transaction that increases cash is a source of funds and any transaction that reduces cash is a use or an application of funds Cash flow statements are prepared for use monitoring an entity’s cash movements

8. Definition of funds According to the Framework, “information concerning cash movements of an entity is useful in order to assess its investing, financing and operating activities during the reporting period. This information is useful in providing the user with a basis to assess the ability of the entity to generate cash and cash equivalents and the needs of the entity to utilise those cash flows” (para. 18)

9. Definition of funds Sources of cash - Decrease in assets - Increase in liabilities Uses of cash - Increase in assets - Decrease in liabilities

10. Definition of funds Working capital Working capital is measured as current assets less current liabilities An increase in working capital is a source of funds A decrease in working capital is an application (or use) of funds

11. Definition of funds An increase in working capital occurs when there is an increase in total current assets without a corresponding increase in total current liabilities A decrease in working capital occurs in the opposite circumstances The difference between sources and uses of working capital will be equal to the change in working capital between successive balance sheets

12. Definition of funds Total resources This conception of funds is based on an interpretation of the balance sheet as a statement which shows the sources of an entity’s resources and how those resources have been used This approach, as mentioned earlier, was adopted in the first Australian accounting standard on the funds statement

13. Definition of funds Under this view of funds, the obligations side of the balance sheet shows the financial resources that have been provided by lenders and shareholders and the assets side of the balance sheet shows how these resources have been used

14. Definition of funds Any transaction that increases liabilities or equity is a source of funds Any transaction that reduces liabilities or equity is a use of funds Any transaction that increases assets is a use of funds Any transaction that reduces assets is a source of funds

15. Reporting cash flow information Cash flow reporting is justified on the grounds that such information “is useful in providing users of financial reports with a basis to assess the ability of the entity to generate cash and cash equivalents and the needs of the entity to utilise those cash flows” (AASB 107, Objective; also see AASB101, para. 111) Cash flow information is shown by preparing “a cash flow statement which classifies cash flows during a period from operating, investing and financing activities” (Objective)

16. Reporting cash flow information The cash flow statement complements the income statement and the balance sheet It is an essential component of the financial reporting process

17. Reporting cash flow information When used in conjunction with other financial statements, the cash flow statement “provides information that enables users to evaluate the changes in net assets of an entity, its financial structure (including its liquidity and solvency) and its ability to affect the amounts and timing of cash flows in order to adapt to changing circumstances and opportunities” (AASB 107, para. 4, emphasis in original)

18. Accounting standards Definitions are found in para. 6 Cash and cash equivalents are elaborated upon in paras. 7- 9 Classification of cash flows into operating, investing and financing activities (para. 10; also see paras. 11 and 12)

19. Accounting standards For discussion of operating activities (see paras. 13 to 15); investing activities (para. 16) and financing activities (para. 17) The reporting of cash flows from operating activities is to be made using the direct method or approach or the indirect method or approach

20. Accounting standards Under the direct method “major classes of gross cash receipts and gross cash payments are disclosed” [para. 18(a); also see para. 19] Under the indirect method “profit or loss is adjusted for the effects of transactions of a non-cash nature, any deferrals or accruals of past or future operating cash receipts or payments, and items of income or expense associated with investing or financing cash flows” [para. 18(b); also see para.20]

21. Accounting standards

22. Accounting standards “When an entity uses the direct method, a reconciliation of cash flows arising from operating activities to profit or lass shall be disclosed in the financial report” (para. Aus20.1) Reporting cash flows from investing and financing activities (para. 21) Reporting cash flows on a net basis is permitted for operating, investing or financing activities under certain circumstances only as specified (para. 22; also see paras. 23 and 24)

23. Accounting standards Format of the cash flow statement (see H, P & H, p. 604) Interest and dividends (para. 31; also see paras. 32-34) Presentation of cash flows from operating activities (see H, P & H, p. 605-606)

24. Accounting standards One of the limitations of a cash flow statement is that it omits non-cash investing and financing activities, such as acquiring another entity through the issue of shares; acquiring assets by assuming directly related liabilities or converting debt to equity Para. 43 requires note disclosure of investing and financing transactions with external parties that do not require the use of cash or cash equivalents in providing relevant information (also see para. 44)

25. Lecture 12: The choice of accounting methods Introduction Choice by accounting standard setters Choice by financial report preparers

26. Introduction Accounting standard setters and preparers are required to make choices among alternative recognition, measurement and disclosure policies Such choices are influenced by a range of factors Accounting standards themselves may implicitly or explicitly allow choices or broader choices may be available where no specific accounting standard exists on a particular topic

27. Choice by accounting standard setters Accounting standard setters are charged with the responsibility of setting the most appropriate accounting policy or policies from a range of alternatives Such choices are critical as the treatments specified for adoption in accounting standards effectively determine accounting practice (or what is broadly known as “generally accepted accounting practice”)

28. Choice by accounting standard setters The process of choice by accounting standard setters is discussed by H. P & H, pp. 192-196 with regard to four time periods: - Ad hoc period - Conceptual framework period - Harmonisation period - Convergence period

29. Choice by accounting standard setters Ad hoc period Dates from early 1970s to late 1980s Choices were largely political Choices were primarily determined by their acceptability to the business community rather than by their consistency with theoretical considerations

30. Choice by accounting standard setters Conceptual framework period Dates from late 1980s to 1997 The principal reason for establishing the conceptual framework was to assist accounting standard setters in issuing and revising standards Standards based on the conceptual framework were less prone to attack by lobbyists

31. Choice by accounting standard setters Harmonisation period From the mid to late 1990s, support for the harmonisation of Australian accounting standards with International Accounting Standards strengthened A program was adopted to ensure greater consistency between Australian and IAS accounting standards This period closed in June 2002

32. Choice by accounting standard setters Convergence period Dates from June 2002 when the Financial Reporting Council announced that AASB standards would be converged with accounting standards of the IASB. In effect, Australia adopted IASB accounting standards (that are known as AIFRS) for application to reporting periods beginning on or after 1 January 2005

33. Choice by financial report preparers Preparers are to choose accounting policies and adopt accounting treatments that are best suited to particular transactions and other past events H, P & H, pp. 197-210 discuss this choice under the following headings: - Availability of choice - Creative accounting - Positive accounting theory

34. Choice by financial report preparers Availability of choice Standards do not exist of all accounting topics Choice is often available within accounting standards on issue Professional accountants make judgements in specific circumstances about matters which have conclusions in the future, thus necessarily leading to the use of assumptions and estimates in financial reporting The exercise of judgement is the hallmark of the professional accountant

35. Choice by financial report preparers Creative accounting The making of choices in order to present the impression desired by preparers Accountants may be “creative” in their: - Choice of accounting policies - Estimates or predictions - Disclosure - Timing of transactions

36. Choice by financial report preparers Positive accounting theories The key theories or research approaches are known as: - Income-smoothing hypothesis - Contracting and agency theories

37. Choice by financial report preparers Income-smoothing hypothesis Under this theory, shareholders’ satisfaction with managers increases as managers achieve dependable rates of growth and stable reported profits Research, especially in the late 1960s and 1970s, suggests inconclusive results

38. Choice by financial report preparers Contracting and agency theories Individuals act to advance their own self-interest but appear to take the interests of others into account in acting in their own interests Such theories assume that individuals are wealth maximisers Accounting policy decisions with respect to recognition, measurement and disclosure affect wealth or, indeed, the determination of wealth for distribution to stakeholders

39. Choice by financial report preparers Under contracting theory, a firm is a collection of self-interested individuals who agree to co-operate Cooperation is obtained through contracts The process of contracting is costly “Contracting costs” include “agency costs” which arise in agency relationships such as between the owner and the manager or between the debt holder and the manager Contracts include bonding and monitoring arrangements

40. Choice by financial report preparers Agency costs consist of the costs incurred to reduce opportunistic behaviour, plus the costs of those forms of opportunistic behaviour that it is uneconomic to eliminate Accounting assists in contract design and also provides data for monitoring the terms of the contracts Accounting is not passive score-keeping and accounting policy decisions are not neutral Contracting theory predicts that agents will choose the form of accounting that best serves their self-interest

41. Choice by financial report preparers According to H, P & H (p. 210), “generally accepted accounting principles are those that have been found to be cost effective in limiting the harmful effects of the conflicting interests of the parties” Opportunistic behaviour cannot be eliminated as Enron and WorldCom in the United States and HIH and OneTel in Australia, among other recent cases of corporate collapse, confirm and future examples are surely on the way